Integrating ESG Factors in the Investment Process

Investors are always looking for new and innovative ways to improve their portfolios and achieve better returns. One strategy that is gaining popularity is integrating environmental, social, and governance (ESG) factors into the investment process. ESG investing considers how a company’s policies or practices could impact society and the environment, in addition to its financial performance. While there are some skeptics out there who think ESG investing is just a fad, research shows that it can be an effective way to manage risk and achieve long-term growth. If you’re interested in learning more about ESG investing, keep reading! We’ll discuss the basics of this approach and show you how you can get started.

What are ESG factors?

Before we start, it is important to understand what ESG is why it matters. Are you familiar with the word sustainability? ESG is about considering sustainability when investing. In fact, ESG is also called sustainable or responsible investing. Sustainability means different things to different people, but in the investment world it includes a focus on environmental, social and governance issues that can affect a company’s bottom line. This is in contrast with only focusing on a company’s financial performance when considering whether or not to invest.

Sustainable investing is important because it:

  1. It rewards companies that are making an effort to be sustainable
  2. It lets anyone support the shift to a sustainable world
  3. It can help you avoid companies that aren’t making an effort to consider sustainability

ESG investing has been around for decades, but only started getting popular in the early 2000s. And it’s really picked up steam in recent years – research shows that ESG funds saw compound annual growth of 15% from 2013-2015 and another 21% from 2015-2017. We are not even past the first quarter of this year and it is estimated that over $120 Billion have gone into ESG exchange-traded funds so far this year.

“We are seeing 2022 as the year when ESG not only becomes mainstream, but it starts driving markets a lot more,” said Aniket Shah, Head of ESG and Sustainability Research at Jefferies Global. He explained further “And the reason why this will happen is because core parts of the financial system, including the central banks, are going to become even more serious about climate change as they are today.” This will be driven by regulatory changes as national governments and central banks get serious about climate change and decarbonization targets. Collectively, we can no longer ignore the impending effects of climate change.

Today, many asset management companies have added ESG analysis to their research reports and also have ESG strategies for individual investors.

Financial research has found that companies with good ESG practices outperform their counterparts.

What are the 3 main categories of risk associated with ESG investing?

  1. Environmental – These types of risks consider the effect a company has on the environment when producing goods and services. The most common risks include climate change, pollution and resource depletion. Some examples of ESG companies that address this type of risk are wind turbine manufacturers or green energy providers.
  2. Social – These types of risks consider how a company treats its employees, community members and business partners. Some examples of social risks might be labor rights, human trafficking, or community relations. For example, a company that provides its employees with opportunities for advancement is less likely to have labor risk than one that doesn’t.
  3. Governance – These types of risks consider how well-governed the company is. They include risks like corruption, accounting fraud or cyber security attacks. For example, if companies are not governed well it is likely they will not be in compliance with environmental and social standards.

What are the Principles of ESG?

Within the investment community, there is some debate about what ESG investing actually means and how it should be carried out. Some investors prefer to avoid certain industries or countries that could be risky based on their social or environmental policies.

On the other hand, some people believe ESG investing is a way to make a positive impact on the world, and should include companies that give back through programs designed to improve their communities. Sustainable business practices have proven themselves to be good for investors and the environment.

In general, though, there are some principles or guidelines that most investors agree on when it comes to ESG:

  1. Companies should minimize environmental impacts and emissions and be transparent about their carbon footprint. They should also advocate for clean energy policies and be able to track their environmental progress.
  2. Companies should treat their employees with fairness, pay them fairly, and offer ample opportunities for career development.
  3. Investors should only buy companies that are committed to ethical business practices. Specifically, they shouldn’t do business with companies involved in corruption or bribery of government officials, corruption of other business practices, or child and forced labor.
  4. Companies should have comprehensive policies that satisfy certain human rights criteria, including discrimination in hiring and working conditions for women and minorities, eliminating child or forced labor from their supply chains , and compliance with international standards such as the UN Global Compact.

So, what is ESG investing?

As we just learned, ESG investing is more than just considering the environment or social issues of a company. It can impact your investment decisions. Up until recently, it had mostly been an ethical consideration for some investors looking to protect their portfolios from companies with risky policies.

But financial research has found that ESG factors can also be quantitatively valuable as a way to manage risk and achieve long-term growth. In fact, there is now a field of ESG research that studies how ESG factors can impact a company’s financial performance. This is similar to the research investors have been doing for decades on traditional investment factors such as market capitalization or P/E ratio. And the data shows that investing in sustainable business is good for people, planet and profit.

What are some of the risks that ESG factors can help manage?

ESG research shows that companies with better environmental practices, for example, tend to be more profitable. They may also have fewer accidents, higher product quality and customer loyalty.    

On the other hand, companies with lower social scores are more likely to suffer from reputational damage, boycotts and divestment campaigns that can affect their bottom line.

What are the risks to investors associated with ignoring ESG factors?

Regulatory change: Governments have been promoting more ethical practices by passing regulations to ensure all companies follow certain ESG guidelines. For example, the UK government has a plan to require large businesses listed on its stock exchange to report their greenhouse gas emissions from 2014. The United States is also increasing the number of regulations affecting corporate social responsibility, environmental protection and other ESG factors.

Financial research has found that companies with good ESG practices outperform their counterparts. So, this regulation is going to have a big impact on which companies investors buy into and who will be the leaders in the market.

Noisy media: The spread of “noisy” social media information: Social media makes it easy for people to share their opinions about a company or their products. A company’s social media profile can make it easy to spread “noisy” information about internal business practices- especially if the company is doing something unethical.

For example, if a customer posts a negative review on Facebook about your company overcharging fees, it can quickly go viral and affect your sales. This sort of information can be much more difficult to correct and manage than a simple customer service call.

Customer loyalty: The loss of customer loyalty: If your company doesn’t align with your customers’ values, you could lose business. For example, many investors now see climate change as a massive risk for not only the planet but also their portfolios. According to one survey , 64% of investors are now integrating ESG into their investment decisions.

Reputational damage: Companies with good reputations tend to do better in both the short term and long term. A company’s reputation determines how customers perceive it, which can affect its success over time. For example, if your company supports a cause that many people find offensive, it may negatively affect your bottom line.

This can also affect a company’s ability to attract top talent and secure good deals with suppliers, which could impact its long-term profitability.

For example, if a supplier realizes that your company doesn’t align with their values, they might refuse to do business with you. Or perhaps they find questionable actions in your supply chain. This can be especially true for those in the extractives industry, as their reputations have been plagued by news of human rights violations.

bar graph of portfolio investments for sustainable investing

So what can investors do?

One way to protect your portfolio from risk is to invest in mutual funds or ETFs that have a sustainable focus . These are managed with the same criteria as traditional investment products, but they focus on companies with a proven commitment to ESG factors. For these products, your money can still go towards growth because ESG companies tend to outperform traditional investment funds over the long-term.

Another option is to invest in an SRI or Socially Responsible Investment fund . These products are aimed at socially responsible investors who want ethical investments that reflect their beliefs.

What to Look for when Investing in ESG Mutual Funds or ETFs

There are many things to consider when evaluating an ESG investment, including the type of companies the fund invests in, how much money goes towards risk reduction, and how well it aligns with your personal beliefs. It’s also important to look at the fund’s governance and whether it is transparent about its ESG initiatives as well as its performance against traditional investment benchmarks.

The best way to compare funds is by looking into their relative “impact.” Funds with a high impact focus on companies that have the greatest positive impact on society, such as those that are leaders in promoting environmental initiatives. Low impact funds, on the other hand, invest in companies with little to no negative environmental impacts.

Companies working towards ESG goals tend to outperform traditional investment funds over the long-term because they have less risk associated with them. By taking these factors into account when investing, you can enjoy the best of both worlds.

How do you integrate ESG in investment process?

The first step to integrating your investment portfolio is to identify which ESG criteria are important to you. This involves identifying what your long-term goals are, as well as the social and environmental issues that are most important to you.

For example, if climate change is a cause that’s close to your heart, focus on investing in renewable energy companies. If you’re passionate about education reform, you could invest in a fund that focuses on companies with good corporate governance and strong ESG records. If you are concerned about child labor, then focus on companies with transparent supply chains.

The next step is to spread your money across several ESG funds that focus on different factors, giving you the best chance of investing in companies with great records across the board.

4 important things to consider when evaluating an ESG fund

After you’ve identified your investment preferences, it’s time to find the best fund for you. Here are some important things to consider when evaluating an ESG fund:

  1. Look at how much money goes towards risk reduction as well as performance against traditional investment benchmarks.
  2. Factors in the fund’s governance and whether it is transparent about its ESG initiatives as well as performance .
  3. Look at the type of companies the fund invests in, how it aligns with your personal beliefs.
  4. Compare “impact” – high impact funds invest in companies that have a greater positive impact on society, such as those that are leaders in promoting environmental initiatives. Low impact funds on the other hand invest in companies with little to no negative environmental impacts.

What is ESG in investment management?

Sustainable investment management is the integration of environmental, social, and governance (ESG) factors into investment analysis and decision-making processes. ESG issues are at the forefront of keeping boards in compliance with best practices to protect core company values and reduce risk. It is prudent to use an investment manager for many reasons whether you are investing in sustainability or strictly for profit.

The best way to compare funds is by looking into their relative “impact.”

3 best reasons to use an investment manager for ESG investing

  1. Compliance with legal standards: Sustainable investment managers are able to meet the regulatory demands of different jurisdictions. This includes, but is not limited to, compliance issues associated with local environmental regulations, employment law, anti-corruption requirements, and international conventions on bribery. Many finance professionals have found it much easier to hire an ESG manager to manage their company’s ESG compliance.
  2. Minimizing risk and increasing returns: It is well documented that certain companies have higher financial performance over time when environmental, social, and governance factors are embraced in their business models. These companies can be categorized as being proactive with respect to the environment, having a culture of good corporate citizenship, and having strong mechanisms for monitoring and managing risks. The sustainable investment management industry has researched this phenomenon thoroughly, which provides investors with more information on making sound financial decisions.
  3. Adding value to investing: Sustainable investment management adds an additional element of value to the capital markets by using ESG factors in their decision-making process. This helps companies and investors be proactive about people, planet, profit.

What does an ESG manager do?

An ESG manager has the responsibility of identifying companies (PwC ESG survey), that prioritize ESG issues within their overall business practices. Once identified, sustainable investment managers can then use an ESG rating methodology to rate and rank them on a spectrum of “good” to “poor”. They identify companies by looking at the management, products, workforce, customer base, intangible assets and suppliers.

Companies which have performed their own ESG audits may already have an ESG Score in place. This score, which ranges from 0-100 can be used by ESG managers as a guide to rate the company accordingly.

ESG ratings have been developed for a variety of industries and types of companies, from those that are very specific such as restaurants or those that are more general such as technology companies.

Choosing an investment manager with ESG integration makes sense for many reasons. One is to be proactive instead of reactive when it comes to holding companies accountable. Another is the ability to offer investors more information on making sound financial decisions.

When looking at integrating ESG facts in your investment process, know why you are investing and what you want out of it. Having a clear understanding of whether you wish to be proactive or reactive will help you determine what type of investment manager to use.

What are the 2 types of sustainable investment managers?

  1. Proactive: An ESG manager who is proactively investing in companies that have a high rating and ranking.
  2. Reactive: A company who has performed their own ESG audits and has an ESG score which can be used as a guide for ESG managers to rate the company accordingly.

Reactive investment managers tend to focus on companies that have done an excellent job at reporting both financially and environmentally. They use this information as their primary source for making decisions.

Proactive investment managers, may take a different approach by simply looking at companies which prioritize ESG issues within their overall business practice.

Integrating ESG factors into investment decision making is happening across all asset classes.

How can a company use ESG integration?

Companies that prioritize the environment, society and governance factors within their operations often have a competitive advantage in their respective industries, which is why many companies are integrating ESG into their strategies.

Innovative ways of communicating sustainability on an international level is driving competition for investment dollars to those companies that are recognized as being sustainable.

Many corporations have found success in using an ESG Score to communicate externally, while continuing their internal conversation on how best to integrate these factors into their operations.

ESG integration is also increasing the demand for sustainable products and services which can drive financial growth within a company. This will help the company grow their brand equity.

How does a sustainable investment manager know what to look for?

A sustainable investment manager uses a range of ESG information to help make their investment decisions. Sustainable systems compliant with the Principles for Responsible Investment (PRI), The United Nations Environment Programme Finance Initiative (UNEP FI) and Global Reporting Initiative (GRI) can provide a range of information from public disclosures to open-ended engagement. ESG managers also take into account market-based research, focusing on environmental, social and governance factors in their investment analyses.

What is a sustainable investment consultant?

Sustainable investment consultants are local experts who have developed a deep local market knowledge and can use their position to promote sustainable development. The role of a consultant is to provide the necessary information, tools and guidance for investment decision makers in order for them to integrate ESG factors into their investment process.

What are some of the most common areas where ESG integration is occurring?

Integrating ESG factors into investment decision making is happening across all asset classes. Some of the most common are listed below.

Real estate portfolio managers are integrating ESG factors into their investment process by using indicators to score assets within a property, by developing products that meet these standards and working with companies to integrate sustainable practices in order to maintain long-term investments.

Power and utilities managers are integrating ESG factors into their investment process by looking at the environmental impact of power generation and distribution, as well as opportunities for companies to build more efficient production facilities that can reduce emissions.

Fixed-income portfolio managers are using ESG data to identify which companies have good business practices and policies in place around social issues. This impacts sovereign, corporate and securitized bond portfolios.

Equity managers are using ESG factors to identify companies that have good business practices in place which contribute to the health of their environment or society. This is often referred to as ESG integration or Environmental Social Governance integration (ESGI).

In conclusion on sustainable investing and institutional investors

Investors can feel confident knowing that there are skilled professionals who manage ESG in a range of investment processes in a way that is low cost and accessible. ESG integration can be a confusing topic, but it doesn’t have to be. We’ve outlined some of the most common approaches to integrating ESG into your investment process and also discussed what ESG factors are and how they work. If you’re looking for an easy way to get started with ESG investing, we suggest checking out asset managers who rank high for their ESG practices. Though there is no one-size-fits-all answer when it comes to sustainable investing, we believe that making small changes in your portfolio can have a big impact down the line. Are you ready to make your money go further?